Increasing provisions to soften REC’s return ratios

High costs and increasing stress in loan assets are taking their toll on Rural Electrification Corp. Ltd’s (REC) return ratios. Interest income of the firm grew by a robust 29% in fourth quarter last fiscal. But the strong growth did not translate into profits, which rose by a modest 9%.

Two key variables are crimping profit growth at the company. One is interest costs. From 7.75% in the fourth quarter of 2010-11, the cost of funds increased by 39 basis points to 8.14% in January-March this year. One basis point is one-hundredth of a percentage point.

High cost of funds led to a 35% jump in interest expenses, which weighed on the interest margins. Compared with the year ago period, net interest margins in the fourth quarter of 2011-12 contracted by 15 basis points to 4.26%. Other income, meanwhile, slumped by 49% as the company did not accrue any foreign exchange gains during the quarter.

As the company deploys more funds through capital gains and tax exemption bonds, interest costs are expected to ease in coming quarters.

Analysts are not too worried about the business prospects. What they are concerned about, though, is asset quality. The troubled transmission and distribution segment constitutes half of the company’s loan book. With state electricity boards financially stressed, many loan assets are being restructured.

According to Edelweiss Securities Ltd, the company has restructured Rs 11,000 crore, or around 10% of its loan assets in the fourth quarter. Against the restructured assets, it has set aside Rs 3.18 crore.

Even though it did not provide for any bad debts last quarter, the provisions, on average, are on the rise. From a paltry Rs 22 lakh in 2010-11, provisions for doubtful and restructured loans jumped to Rs 52.27 crore last fiscal. They are expected to rise.

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According to Antique Stock Broking Ltd, the company’s board has proposed to set aside 3% of the annual profits for loan loss provisioning from the current fiscal onwards. Setting aside more money for restructured assets could weigh on return ratios as they are directly charged to the company’s operating profits.

Return ratios are already softening. From 21.53% in 2010-11, return on net worth contracted 107 basis points to 20.46% last fiscal. In the fourth quarter, they eased by 108 basis points to 21.03% from a year-ago period.

Net non-performing assets (NPAs), on the other hand, rose from Rs 2 crore in 2010-11 to Rs 426 crore, or 0.42% of the outstanding loans last fiscal. True, NPAs are a minuscule part of the company’s outstanding loans. But a combination of increasing provisions and bad loans could have considerable impact on the company’s return ratios.

The concerns are already weighing on stock performance. Against BSE-100 index’s fall of 7%, the stock lost 17% of its value since the beginning of April this year. At Rs 169.50, the stock is trading at a slight premium to its book value of Rs 149.

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